# Does Y determine MV or is it MV that determines P?

Scott Sumner a couple of days ago wrote a post on the what he believes is a Great Stagnation story for the US. I don’t agree with Scott about his pessimism about long-term US growth and I don’t think he does a particularly good job arguing his case.

I hope to be able to write something on that in the coming days, but this Sunday I will instead focus on another matter Scott (indirectly) brought up in his Great Stagnation post – the question of causality between nominal and real shocks.

This is Scott:

“I’ve been arguing that 1.2% RGDP and 3.0% NGDP growth is the new normal.  The RGDP growth is of course an arbitrary figure, reflecting the whims of statisticians at the BEA.  But the NGDP slowdown is real (pardon the pun.)”

The point Scott really is making here (other than the productivity story) is that it is real GDP that determines nominal GDP (“NGDP slowdown is real”). That doesn’t sound very (market) monetarist does it?

Is this because because Scott – the founding father of market monetarism – suddenly has become a Keynesian that basically just thinks of nominal GDP as a “residual”?

No, Scott has certainly not become a Keynesian, but rather Scott fully well knows that the causality between nominal and real shocks – whether RGDP determines NGDP or it is the other way around – is critically dependent on the monetary policy regime – a fact that most economists tend to forget or even fail to understand.

Let me explain – I have earlier argued that we should think of the monetary policy rule as the “missing equation” in the our model of the world. The equation which “closes” the model.

It is all very easy to understand by looking at the equation of exchange:

M*V=P*Y

The equation of exchange says that the money supply/base (M) times the velocity of money (V) equals the price level (P) times real GDP (Y).

The central bank controls M and sets M to hit a given nominal target. Market Monetarists of course have argued that central banks should set M so to hit an nominal GDP target. This essentially means that the central bank should set M so to hit a given target for P*Y.

We know that in the long run real GDP is determined by supply side factors rather than by monetary factors. So if we have a NGDP target then the central bank basically pegs M*V, which means that if the growth rate in Y drops (the Great Stagnation story) then the growth rate of P (inflation) will increase.

So we see that under an NGDP targeting regime the causality runs from M*V (and Y) to P. Inflation is so to speak the residual in the economy.

But this is not what Scott indicates in the quote above.

This is because he assumes that the Fed is targeting around 2% (in fact 1.8%) inflation. Therefore, IF the Fed in fact targets inflation – rather than NGDP – then in the equation of exchange the Fed “pegs” P (or rather the growth rate of P).

Therefore, under inflation targeting the Fed will have to reduce the growth rate of M (for a given V) by exactly as much has the slowdown in (long-term) growth rate of Y to keep inflation (growth P) on track.

This means that under inflation targeting shocks to Y (supply shocks) determines both M and P*Y, which of course also means that “NGDP slowdown is real” (as Scott argues) if we combine a slowdown in long-term Y growth and an inflation targeting regime.

Scott won – so he is wrong about causality

Scott since 2009 forcefully has argued that the Federal Reserve should target nominal GDP rather than inflation. I on the other hand believe that Scott has been even more succesfull than he believes and that the Federal Reserve already de facto has switched to an NGDP targeting regime (targeting 4% NGDP growth). Furthermore, I believe that the financial markets more or less realise this, which means that money demand (and therefore money-velocity) tend to move to reflect this regime.

This also means that if Scott won the argument over NGDP targeting (in the US) then he is wrong assuming that that real shocks will become nominal (that Y determines M*V).

The problem of course is that we are not entirely sure what the Fed really is targeting – and neither is most officials. As a consequence we should not think that the monetary-real causality in anyway is stable. This by the way is exactly why we can both have long and variable leads and lags in monetary policy.

For further discussion of these topics see these earlier posts of mine:

The monetary transmission mechanism – causality and monetary policy rule

Expectations and the transmission mechanism – why didn’t anybody think of that before?

How (un)stable is velocity?

The missing equation

The inverse relationship between central banks’ credibility and the credibility of monetarism

# When central banks ignore the Tinbergen rule – the case of RBNZ

The news from the global currency markets this morning:

New Zealand’s dollar was set for its biggest three-day drop since 2011 after the Reserve Bank said its sales of the currency in August were the most in seven years. The greenback headed for its best month since 2012

The kiwi dropped against all 31 major counterparts as Prime Minister John Key was reported as signaling that the currency needs to be weaker. Australia’s dollar declined below 87 U.S. cents for the first time since January. The Hong Kong dollar weakened along with equities in the Asian city amid the largest police crackdown on protesters since it returned to Chinese rule. The euro fell to its lowest in 22 months versus the greenback before the European Central Bank meets Oct. 2.

Everything is wrong about this. I normally think that the Reserve Bank of New Zealand (RBNZ) is doing a fairly good job, but over the past couple of years it has become increasingly erratic in its behaviour and seems to be having a problem focusing on its stated objective of keeping inflation close to its inflation target.

Hence, the RBNZ has in recent years had a pre-occopation with the development in the New Zealand property market and household debt etc. and now it is the level of the kiwi dollar, which is on the mind of the RBNZ. And maybe worse the Prime Minister is now also thinking that he should get involved in monetary policy decision making – at least indirectly.

You gotta ask yourself what monetary policy goal the RBNZ have? After all you cannot have the cake and it eat too. That is the Tinbergen rule – you can only have one policy objective for each policy instrument.

The intervention in the currency market seems particularly odd when we remember that the RBNZ is not unlike a lot of other central banks stuck at the Zero Lower Bound – RBNZ’s policy rate the Overnight Cash Rate is 3.5%. Said, in another way if the RBNZ thinks that the strengthening of the kiwi dollar in anyway was threatening its key policy objective (1-3% inflation) then it can just got the key policy rate.

Furthermore, the New Zealand economy does not exactly look like it needs monetary easing – real GDP growth is outpacing potential growth, inflation is within the inflation target range and inflation expectations seem to be quite close to the 2% mid-point of the inflation target range. And any Market Monetarist would of course also notice that nominal GDP growth has been extreme buoyant over the past year (admittedly it is slowing now).

The strong growth in nominal GDP during 2013 to a large extent reflected a sharp rise in New Zealand’s export prices particular higher dairy prices. That trend has changed significantly in 2014 and that has actually put considerable depreciation pressure on the kiwi dollar recently, but apparently there is enough pressure on the kiwi dollar if you listen to Prime Minister John Key and the RBNZ.

Just ask yourself the question what if the kiwi dollar remains “too strong” for the liking of the RBNZ and the Prime Minister and the RBNZ decides to intervene more what would then happen? What is currency intervention? It is money creation. The RBNZ would print kiwi dollar – expanding the money base.

That eventually will spur NGDP growth and with the economy operating at more or less full capacity utilisation this will spur inflation and increase inflation expectations above the RBNZ’s inflation target. So the question is how much higher inflation will the RBNZ be willing to accept to weaken the kiwi dollar? Will it be willing to jeopardize its inflation target?

This demonstrates that the RBNZ only permanently can weaken the kiwi dollar if it is compatible with the RBNZ’s inflation target. Unless of course the New Zealand government is willing to introduce capital and currency controls. That luckily that does not seem to be on the agenda.

If the RBNZ is targeting inflation then the RBNZ will have to accept the level for the kiwi dollar, which is determined by market forces. If it on the other hand wants to target the exchange rate then it fundamentally will have to give up its inflation target.

I don’t think that the RBNZ is going to mess up things dramatically, but the RBNZ’s pre-occopation with the level of the kiwi dollar is yet another example that central bankers around the world still fundamentally have a hard time accepting the logic of the Tinbergen rule. But there is no way around it – you can only have one monetary policy target – the inflation rate, the price level, the NGDP level or the exchange rate. You can’t do it all.

PS I have often argued that central banks in small open economies use the exchange rate as an way implement monetary policy if it is stuck at the Zero Lower Bound and if monetary easing is needed. However, that is not the case for the RBNZ.

PPS Maybe I am wrong and it might just be the case that the RBNZ knows better than the market – just see here (I don’t really think I am wrong…)

PPPS The RBNZ does not exactly have a good experience playing around with quasi-exchange rate targeting. See here.

# The dollar rally is testing the Fed’s credibility

The dollar has continued to strengthen since early July – just take a look at the graph below:

As the graph shows not only has the dollar strengthened since July, but inflation expectations have also dropped somewhat and interesting enough we have now 10-year break-even inflation expectations below 2%.

It is only the second time that that have happened since the Fed officially introduced a 2% inflation target in January 2012 (see here). Obviously we cannot directly compare the Fed’s inflation target and 10-year inflation expectations, but the decline in inflation expectations nonetheless is very indicative of the scale of monetary tightening that is expected from the Fed.

The graph also shows there is a very close negative correlation between the performance of the US dollar and US inflation expectations. This obviously can easily been explained from a monetary perspective. Expectations for Fed tightening (easing) will both cause the dollar to strengthen (weaken) and cause inflation expectations to drop (rise).

The close correlation between inflation expectations and the dollar means that a continued strengthening of the dollar will be a clear test of the Fed’s credibility and if the dollar continues to rally then it would be very obvious to everybody that the Fed’s credibility would be under pressure.

I am not speculating here whether the dollar rally will continue or not, but rather whether Fed’s inflation target is credible or not?

# David Beckworth says goodbye to inflation targeting

David Beckworth just sent me a new paper – Inflation Targeting: A Monetary Policy Regime Whose Time Has Come and Gone – he has written on why it is time to say goodbye to inflation targeting.

Here is the abstract:

Inflation targeting emerged in the early 1990s and soon became the dominant monetary-policy regime. It provided a much-needed nominal anchor that had been missing since the collapse of the Bretton Woods system. Its arrival coincided with a rise in macroeconomic stability for numerous countries, and this led many observ- ers to conclude that it is the best way to do monetary policy. Some studies show, however, that inflation targeting got lucky. It is a monetary regime that has a hard time dealing with large supply shocks, and its arrival occurred during a period when they were small. Since this time, supply shocks have become larger, and inflation targeting has struggled to cope with them. Moreover, the recent crisis suggests it has also has a tough time dealing with large demand shocks, and it may even contribute to financial instability. Inflation targeting, therefore, is not a robust monetary-policy regime, and it needs to be replaced.

David is an extremely clever guy and everything he writes on monetary matters is very interesting and insightful so it would be rather foolish not to read his latest paper. I will start right away – there is after all no World Cup football tonight!

# Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

# The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation…

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting.

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

# Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?

# The scary difference between the GDP deflator and CPI – the case of Japan

Most inflation targeting central banks in the world are targeting inflation measured by the Consumer Price Index (CPI). However, if you want to target inflation CPI is probably the worst possible measure to focus on. Why? Because CPI includes both indirect taxes and import prices – something the central bank can certainly not control.

If the central bank targets CPI it would in fact have to tighten monetary policy in response to negative supply shocks such as rising oil prices. Similarly the CPI targeting central bank would effectively be “forced” to tighten monetary policy in response increases in indirect taxes. Do you think this is foolish? Well, the ECB is doing it all the time…just think of the catastrophic rate hikes in 2011 in response to higher oil prices and austerity induced indirect tax increases across the euro zone.

A much better measure to target – if you want to maintain an inflation targeting (I don’t…) – would be to target the so-called GDP deflator as this measure of prices by definition excludes import prices and indirect taxes. Targeting the GDP deflator therefore would reduce the problem of monetary policy reacting to positive and negative supply shocks.

You might think that the difference between CPI and the GDP deflator is small and frankly speaking that used my view. However, the difference is far from trivial, which the case of Japan’s deflationary experience over the past 15-17 years clearly illustrates. The graph below shows the development in the Japanese price level measured by both CPI and the GDP deflator.

While CPI indicates that the Japanese price level today is around 2% lower than in 1995 the GDP deflator is telling us that prices have dropped nearly 20% in the last 17 years. The difference is stunning and is certainly not something that should be ignored, but unfortunately I doubt that most central bankers are aware about just how great these differences are.

It should of course be stressed that it is not normally so that CPI will be upward biased compared to the GDP deflator, but if tight monetary policy is leading to long periods of low or no growth and that forces the government to increase indirect taxes to improve public finances – as it has been the case in Japan – then there very likely will be an upward biased in the CPI compared to the GDP deflator.

This conclusion obviously is highly relevant for the conduct of monetary policy in the present situation – particularly in the euro zone, where governments around Europe are increasing indirect taxes in a more or less desperate attempt to improve public finances. With the ECB’s focus on consumer prices (the HICP in the euro zone) rather than on the GDP deflator higher indirect taxes implicitly leads to tighter monetary policy – something which is hardly warranted in the present situation.

Therefore if central banks want to continue targeting inflation they should at least change from CPI targeting to GDP deflator targeting – that would be a small, but important step away from repeating the Japanese scenario.

PS This discussion is less relevant for the Federal Reserve as the Fed is targeting a the PCE core inflation measure, which is much closer to the GDP deflator than to CPI.

Related posts:

# Jeff Frankel restates his support for NGDP targeting

It is no secret that I have been fascinated by some of Havard professor Jeff Frankel’s ideas especially his idea for Emerging Markets commodity exporters to peg the currency to the price of their main export (PEP). I have written numerous posts on this (see below) However, Frankel is also a long-time supporter of NGDP target and now he has restated is his views on NGDP targeting.

Here is Jeff:

“In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting.   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean(1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.

Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)”

So far so good…and here is something, which will make all of us blogging Market Monetarists happy:

“But now nominal GDP targeting is back, thanks to enthusiastic blogging by ScottSumner (at Money Illusion), LarsChristensen (at Market Monetarist), David Beckworth (at Macromarket Musings),Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.”

This is a great endorsement of the Market Monetarist “movement” and it is certainly good news that Jeff so clearly recognize the work of the blogging Market Monetarists. Anyway back to the important points Jeff are making.

“Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.”

Exactly! The great advantage of NGDP level targeting compared to other monetary policy rules is that it handles both velocity shocks and supply shocks. No other rules (other than maybe Jeff’s own PEP) does that. Furthermore, I would add something, which is tremendously important to me and that is that unlike any other monetary policy rule NGDP level targeting does not distort relative prices. NGDP level targeting as such ensures the optimal and unhampered working of a free market economy.

Back to Jeff:

“Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.   (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.)  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target – and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.”

I completely agree. I have always found the idea of temporary changing the inflation target to be very odd. The problem is not whether to target 2,3 or 4% inflation. The problem is the inflation targeting itself. Inflation targeting tends to create bubbles when the economy is hit by positive supply shocks. It does not fully response to negative velocity shocks and it leads to excessive tightening of monetary policy when the economy is hit by negative supply shocks (just have look at the ECB’s conduct of monetary policy!)
Market Monetarists advocate a clear rule based monetary policy exactly because we think that expectations is tremendously important in the monetary transmission mechanism. A temporary change in the inflation target would completely undermining the effectiveness of the monetary transmission mechanism and we would still be left with a bad monetary policy rule.
Let me give the final word to Jeff:
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.
_______
Some of my earlier posts on Jeff’s ideas:

Scott Sumner also comments on Jeff’s blogpost.

# The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPS Jeffrey Frankel has a very good article on the Death of Inflation Targeting at Project Syndicate. Scott also comments on Jeff’s article. Marcus Nunes also comments on Jeff’s article.

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…